Asked May 14, 2019

Lou’s preferences over pizza (x) and other goods (y) are given by U(x, y) = 2xy2. His income is $200.

a) Calculate his optimal basket when Px =4 and Py = 1.

b) Calculate his income and substitution effects of a decrease in the price of food to $2.

c) Calculate the compensating variation of the price change.

d) Calculate the equivalent variation of the price change.


Expert Answer

Step 1

Since we are entitled to answer up to 3 sub-parts, we’ll answer the first 3. Please resubmit the question and specify the other subparts you’d like answered.

Step 2

Utility: The utility is the power or ability of the commodity to satisfy the consumers want. Alternatively, the satisfying power of commodity is called utility.

Step 3

(a) The Optimal basket when Px =4 and Py = 1

Budget Line = I = PxX  + PyY

200 = PxX  + PyY

Utility function, U(x,y)=2xy2

MUx = 2y2

MUy = 4xy

MUx / MUy = Px/Py

2y2 / 4xy = 4 / 1

y = 8x

Insert Y = 8x, in budget line, I = Px x + Py y

200 = 4 * x + 1 * 8x

x = 16.66


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